Benjamin Graham on Liquidating Value

One of the very important concepts that Benjamin Graham discussed in his seminal book, "Security Analysis," was liquidating value. Graham demonstrated in this book that there were viable companies selling below liquidation value in the 1930s (something that isn’t supposed to happen in an efficient marketplace).

While these situations occur much less frequently today, there are cases where equity securities (e.g.stocks of small and illiquid microcap companies) can be traded in the marketplace for less than liquidating value. If we, as investors, want to be able to take advantage of these mispricings, we need to know what to look for. That is the key purpose of this article: to learn what liquidating value is, and how to calculate it.

The best way to learn about liquidating value is to go back to the source material generated by Benjamin Graham – so that’s what we’re going to do.

Below (in italics) is an excerpt from the 1940 second edition of "Security Analysis" by Benjamin Graham and David Dodd. This excerpt addresses what liquidating value is and how to calculate it. It also provides an example of liquidating value, and then concludes by addressing Graham’s thesis regarding liquidating value and current asset value.

Liquidating Value– By the liquidating value of an enterprise we mean the money that the owners could get out of it if they wanted to give it up. They might sell all or part of it to someone else, on a going-concern basis. Or else they might turn the various kinds of assets into cash, in piecemeal fashion, taking whatever time is needed to obtain the best realization from each. Such liquidations are of everyday occurrence in the field of private business.

Realizable Value of Assets Varies with Their Character– A company’s balance sheet does not convey exact information as to its value in liquidation, but it does supply clues or hints which may prove useful. The first rule in calculating liquidating value is that the liabilities are real but the value of the assets must be questioned. This means that all true liabilities shown on the books must be deducted at their face amount. The value to be ascribed to the assets, however, will vary according to their character. The following schedule indicates fairly well the relative dependability of various types of assets in liquidation.

* Note: Retail installment accounts must be valued for liquidation at a lower rate. Rate about 30 to 60%. Average about 50%.

Calculation Illustrated. – The calculation of approximate liquidating value in a specific case is illustrated as follows:

Example: White Motor Company (See table below)

Object of This Calculation. – In studying this computation it must be borne in mind that our object is not to determine the exact liquidating value of White Motor but merely to form a rough idea of this liquidating value in order to ascertain whether or not the shares are selling for less than the stockholders could actually take out of the business. The latter question is answered very definitely in the affirmative. With full allowance for possible error, there was no doubt at all (in 1931) that White Motor would liquidate for a great deal more than $8 per share, or $5,200,000 for the company. The striking fact that the cash assets alone considerably exceed this figure, after deducting all liabilities, completely clinched the argument on this score.

Current-asset Value a Rough Measure of Liquidating Value. – …It will be seen that White Motor’s estimated liquidating value (about $31 per share) was not far from the current-asset value ($34 per share). In the typical case it may be said that the noncurrent assets are likely to realize enough to make up most of the shrinkage suffered in the liquidation of the current assets. Hence our first thesis, viz., that the current-asset value affords a rough measure of the liquidating value.

From the above excerpt, we learn that liquidating value is calculated by 1) applying appropriate discounts to the assets of a company, and then 2) deducting all liabilities.

Back in Graham’s day, all of the liabilities were shown on the balance sheet. Today, however, there are a number of items that may not show up on the balance sheet that would also constitute liabilities to be deducted in the calculation of liquidating value. These could include: 1) off-balance sheet liabilities (e.g., pending lawsuits/litigation), 2) commitments and contingencies, 3) underfunded pensions, 4) management/employee severance costs, and 5) the effect of dilutive securities (stock options, etc.).

Additionally, if the company is losing money, the liquidating value derived from the balance sheet and notes to the financial statements may not be enough to calculate liquidating value. An estimation of how much money the company could lose before business operations stabilize/rebound would also be needed. These types of situations are often referred to as “melting ice cubes” (because persistent operating losses can reduce a company’s assets and liquidating value over time).

So, while the concept of liquidating value is simple, the calculation is complicated by today’s accounting and financial realities.

Notwithstanding these complications, the concept and calculation of liquidating value are powerful tools in the hands of an enterprising investor. Liquidating value provides a concrete basis for calculating worst-case value of a company; and by knowing worst-case value, an investor can buy stock when it is selling at an irrationally low level (and hopefully make some money when the market comes to its senses).

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